New ruling puts Fannie, Freddie in line for windfall MBS recovery

Has there ever been a more lopsided multibillion-dollar case than the Federal Housing Finance Agency’s fraud litigation against the banks that sold mortgage-backed securities to Fannie Mae and Freddie Mac? I don’t think U.S. District Judge Denise Cote of Manhattan, who is overseeing securities fraud suits against 11 banks that haven’t already settled with the conservator for Fannie and Freddie, has sided with the banks on any major issue, from the timeliness of FHFA’s suits to how deeply the defendants can probe Fannie and Freddie’s knowledge of MBS underwriting standards in the late stages of the housing bubble. But even in that context, Judge Cote’s summary judgment ruling Monday – gutting the banks’ defenses against FHFA’s state-law securities claims – is a doozy.

In effect, Cote’s decision will permit FHFA to recover more from MBS issuers than Fannie Mae and Freddie Mac would have made if their MBS investments had paid as promised. Of course, FHFA and its lawyers at Quinn Emanuel Urquhart & Sullivan and Kasowitz, Benson, Torres & Friedman still have to show that the banks knew or had reason to know that their offering documents misrepresented the mortgage-backed securities they were peddling to Fannie Mae and Freddie Mac. But if FHFA meets that burden, the banks can’t ward off claims under the state securities laws of Virginia and the District of Columbia by blaming Fannie and Freddie’s MBS losses on broad declines in the economy and the housing market.

What’s more, those state securities laws give FHFA the right to rescission – or restitution of the entire purchase price of the MBS Fannie and Freddie bought – plus fees, costs and, most importantly, interest. The Virginia statute mandates that securities fraudsters chip up 6 percent interest – more than the scheduled interest rate in many of the MBS trusts in which Fannie and Freddie invested. The banks, in other words, are now exposed to liability far beyond the actual losses Fannie Mae and Freddie Mac suffered – and even beyond what FHFA’s wards would have earned if the MBS trusts had performed exactly as the banks said they would at the time of sale. That extra interest would be a true windfall for FHFA.

Cote rejected the banks’ motion to ask the Virginia Supreme Court for a ruling on whether the state’s securities fraud law permits a so-called loss causation defense. As the judge explains in her ruling, when Congress passed the Private Securities Litigation Reform Act in 1995, it amended Section 12 of the Securities Act of 1933 to permit defendants to limit their liability by showing that a supposed fraud victim’s losses were not attributable to the defendant’s misrepresentations. In the FHFA cases, the banks’ lawyers – led by James Rouhandeh of Davis Polk & Wardwell, for Morgan Stanley, and Thomas Rice of Simpson, Thacher & Bartlett, for Deutsche Bank – tried to persuade Cote that because state securities laws were based on the federal Securities Act, she should look to the amended federal statute to interpret Virginia and D.C. law. Cote rejected the argument, holding that the federal law did not include a loss causation defense until it was amended in 1995. The Virginia and D.C. laws predate that amendment, Cote said, so loss causation cannot be inferred from their texts.

“As defendants concede, no federal court interpreted the ’33 Act as incorporating a loss causation defense before one was added by the PSLRA,” Cote wrote, so “there is no reason to think the Virginia Supreme Court would read a loss causation defense into the Virginia Securities Act if confronted with the question now.”

Cote’s ruling gives FHFA even more leverage in settlement talks than it has previously enjoyed. Time is also working against the banks: The first trial, of FHFA’s claims against Merrill Lynch, is scheduled to begin in June, with trials against Deutshe Bank, Credit Suisse and Goldman Sachs to follow in September. I have a feeling that JPMorgan Chase, which settled last month with FHFA for more than $5 billion, won’t be the last bank to fork over more than $1 billion to the housing conservator.